CHAPTER 4
LONG-TERM FINANCIAL PLANNING AND
GROWTH
KEY CONCEPTS AND SKILLS
• Apply the percentage of sales method
• Compute the external financing needed to
fund a firm’s growth
• Name the determinants of a firm’s growth
• Anticipate some of the problems in planning
for growth
4-2
CHAPTER OUTLINE
1. What Is Financial Planning?
2. Financial Planning Models: A First Look
3. The Percentage of Sales Approach
4. External Financing and Growth
5. Some Caveats Regarding Financial
Planning Models
4-3
FINANCIAL PLAN
To develop an explicit financial plan, managers must establish
certain basic elements of the firm’s financial policy:
• The firm’s needed investment in new assets: This will arise from
the investment opportunities the firm chooses to undertake,
and it is the result of the firm’s capital budgeting decisions.
• The degree of financial leverage the firm chooses to employ:
This will determine the amount of borrowing the firm will use to
finance its investments in real assets. This is the firm’s capital
structure policy.
• The amount of cash the firm thinks is necessary and
appropriate to pay shareholders: This is the firm’s dividend
policy.
• The amount of liquidity and working capital the firm needs on
an ongoing basis: This is the firm’s net working capital decision.
Financial planners have no fewer than six Ps:
4-4
Proper Prior Planning Prevents Poor Performance
FINANCIAL PLANNING
Financial planning formulates the way in which
financial goals are to be achieved. A financial plan
is thus a statement of what is to be done in the
future.
 Growth, by itself, is not an appropriate goal for the
financial manager.
 The appropriate goal for a firm is increasing the
market value of the owners’ equity
 Growth may thus be a desirable consequence of
good decision making, but it is not an end unto
itself
4-5
DIMENSIONS OF FINANCIAL
PLANNING
1. Planning Horizon – divide decisions into short-run
decisions (usually next 12 months) and long-run
decisions (usually 2 – 5 years)
2. Aggregation – all individual projects and
investments the firm will undertake are combined
to determine the total needed investment
3. Assumptions and Scenarios
 Make realistic assumptions about important variables
 Run several scenarios where you vary the assumptions by
reasonable amounts
 Determine, at a minimum, worst case, normal case, and
best case scenarios
4-6
WHAT CAN PLANNING ACCOMPLISH?
• Examine interactions – help management see the
interactions between decisions (ex: financing for
expansion)
• Explore options – give management a systematic
framework for exploring its opportunities
• Avoid surprises – help management identify possible
outcomes and develop contingency plans accordingly
• Ensure feasibility and internal consistency – help
management determine if goals can be accomplished
and if the various stated (and unstated) goals of the firm
are consistent or compatible with one another
4-7
CONCEPT CHECK
• What are the dimensions of the financial planning
process?
• Why should firms draw up financial plans?
4-8
CHAPTER OUTLINE
1. What Is Financial Planning?
2. Financial Planning Models: A First Look
3. The Percentage of Sales Approach
4. External Financing and Growth
5. Some Caveats Regarding Financial
Planning Models
4-9
FINANCIAL PLANNING MODEL
INGREDIENTS
• Sales Forecast – many cash flows depend directly on the level of
sales (often estimated using sales growth rate)
• Pro Forma Statements (pro formas) – setting up the plan using
projected financial statements (balance sheet, income statement
and statement of cash flows), based on projections of key items
such as sales, allows for consistency and ease of interpretation
• Asset Requirements – the additional assets that will be required to
meet sales projections – projected capital spending
• Financial Requirements – the amount of financing needed to pay
for the required assets – debt policy/new equity, and dividend
policy
• Plug Variable – determined by management, deciding what type
of financing will be used to make the balance sheet balance: ex:
external equity, debt, dividends
• Economic Assumptions – explicit
forecasted economic environment
assumptions
about
the
4-10
CHAPTER OUTLINE
1. What Is Financial Planning?
2. Financial Planning Models: A First Look
3. The Percentage of Sales Approach
4. External Financing and Growth
5. Some Caveats Regarding Financial
Planning Models
4-11
PERCENTAGE OF SALES
APPROACH
• Some items vary directly with sales, while others do not.
• Income Statement
 Costs may vary directly with sales – if this is the case,
then the profit margin is constant.
 Depreciation and interest expense may not vary directly with sales
– if this is the case, then the profit margin is not constant.
 Dividends are a management decision and generally do not vary
directly with sales – this influences additions to retained earnings.
• Balance Sheet
 Initially assume all assets, including fixed, vary directly with sales.
 Accounts payable will also normally vary directly with sales.
 Notes payable, long-term debt and equity generally do not vary
directly with sales because they depend on management
decisions about capital structure.
 The change in the retained earnings portion of equity will come
from the dividend decision.
4-12
EXAMPLE: INCOME STATEMENT
ROSENGARTEN CORPORATION
Income Statement
Sales
$1,000
Costs
833
Taxable income
$ 167
Taxes (21%)
35
Net income
$ 132
Dividends
Addition to retained earnings
$ 44
88
Rosengarten has projected a 25 percent increase in sales for the coming year, so we
are anticipating sales of $1,000 × 1.25 = $1,250. To generate a pro forma income
statement, we assume that total costs will continue to run at $833/$1,000 = .833, or
83.3% of sales or in other words will also increase by 25%
ROSENGARTEN CORPORATION
Pro Forma Income Statement
Sales (projected)
$1,250
Costs (83.3% of sales)
1,041
Taxable income
$ 209
Taxes (21%)
44
Net income
$ 165
4-13
EXAMPLE: INCOME STATEMENT
Next, we need to project the dividend payment. This amount is up to
Rosengarten’s management. We will assume Rosengarten has a
policy of paying out a constant fraction of net income in the form of a
cash dividend. For the most recent year, the dividend payout ratio
was this:
Dividend payout ratio = Cash dividends/Net income = $44/$132=1/3
We can also calculate the ratio of the addition to retained earnings to
net income:
Addition to retained earnings/Net income = $88/$132 = 2/3
This ratio is called the retention ratio or plowback ratio, and it is equal
to 1 minus the dividend payout ratio because everything not paid out
is retained. Assuming that the payout ratio is constant, here are the
projected dividends and addition to retained earnings:
Projected dividends paid to shareholders = $165×1/3 = $55
Projected addition to retained earnings = $165×2/3 = 110
$165
4-14
EXAMPLE: INCOME STATEMENT
ROSENGARTEN CORPORATION
Pro Forma Income Statement
Sales (projected)
$1,250
Costs (83.3% of sales)
1,041
Taxable income
$ 209
Taxes (21%)
44
Net income
$ 165
Dividends
$ 55
Addition to retained earnings
110
4-15
EXAMPLE: BALANCE SHEET
Assets
ROSENGARTEN CORPORATION
Balance Sheet
Liabilities and Owners’ Equity
$
Current assets
Cash
Accounts
receivable
Inventory
Total
Fixed assets
Net plant
and
equipment
Total assets
$ 160
$
Current liabilities
Accounts payable
$ 300
440
Notes payable
100
600
$1,200
Total
Long-term debt
Owners’ equity
$ 400
$ 800
$1,800
Common stock and paid-in surplus
$ 800
$3,000
Retained earnings
Total
Total liabilities and owners’ equity
1,000
$1,800
$3,000
On our balance sheet, we assume that some items vary directly with
sales and others do not. For items that vary with sales, we increase
each item by the assumed sales growth. When an item does not vary
directly with sales, we keep the amount unchanged.
4-16
EXAMPLE: BALANCE SHEET
ROSENGARTEN CORPORATION
Partial Pro Forma Balance Sheet
Liabilities and Owners’ Equity
Assets
Projected
Change
from
Previous
Year
Current assets
Cash
Accounts
receivable
Inventory
Total
Fixed assets
Net plant and
equipment
Total assets
Change from
Previous Year
Projected
Current liabilities
$ 200
$ 40
Accounts payable
550
110
Notes payable
750
$1,500
150
$300
Total
Long-term debt
$2,250
$450
Owners’ equity
$3,750
$750
$ 375
$ 75
100
0
$ 475
$ 800
$ 75
$ 0
Common stock and
paid-in surplus
Retained earnings
Total
Total liabilities and
owners’ equity
$ 800
$
1,110
$1,910
110
$110
$3,185
$185
External financing needed (EFN)
$ 565
$565
0
4-17
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EXAMPLE: EXTERNAL FINANCING
NEEDED
• The firm needs to come up with an additional $565 in debt or
equity to make the balance sheet balance.
 TA - TL&OE = $3,750 – 3,185 = $565
• Choose plug variable ($565 EFN)
 Borrow more short-term (Notes Payable)
 Borrow more long-term (LT Debt)
 Sell more common stock (CS & APIC)
 Decrease dividend payout, which increases the Additions To
Retained Earnings
Suppose Rosengarten decides to borrow the needed funds. In this
case, the firm might choose to borrow some over the short term
and some over the long term. For example, current assets increased
by $300, whereas current liabilities rose by only $75. Rosengarten
could borrow $300 − 75 = $225 in short-term notes payable and
leave total net working capital unchanged. With $565 needed, the
remaining $565 − 225 = $340 would have to come from long-term
debt. Table 4.5 shows the completed pro forma balance sheet for
4-18
Rosengarten.
ROSENGARTEN CORPORATION
Partial Pro Forma Balance Sheet
Liabilities and Owners’ Equity
Assets
EXAMPLE: EXTERNAL FINANCING
NEEDED
Projected
Current assets
Cash
Accounts
receivable
Inventory
Total
Fixed assets
Net plant and
equipment
Total assets
Change from
Previous
Year
$ 200
$ 40
550
110
Notes payable
750
$1,500
150
$300
Total
Long-term debt
$2,250
$450
Owners’ equity
$750
Assets
Current assets
Cash
Accounts
receivable
Inventory
Total
Fixed assets
Net plant and
equipment
Total assets
Projected
Current liabilities
Accounts payable
$3,750
Projected
Change from
Previous Year
$ 200
$ 40
550
Change from
Previous Year
$ 375
$ 75
100
0
$ 475
$ 800
$ 75
$ 0
Common stock and
$ 800
paid-in surplus
Retained earnings
1,110
Total
$1,910
Total
liabilities
and
ROSENGARTEN CORPORATION
$3,185
owners’
equity
Pro
Forma Balance Sheet
External financing needed (EFN) Liabilities and Owners’
$ 565 Equity
$
0
110
$110
$185
$565
Projected
Change from
Previous Year
Current liabilities
Accounts payable
$ 375
$ 75
110
Notes payable
325
225
750
$1,500
150
$300
Total
Long-term debt
$ 700
$1,140
$300
$340
$2,250
$450
Owners’ equity
$ 800
$
$750
Common stock and paid-in
surplus
Retained earnings
Total
Total liabilities and owners’ equity
1,110
$1,910
$3,750
110
$110
$750
$3,750
0
4-19
EFN AND CAPACITY USAGE
The assumption that assets are a fixed percentage of sales is convenient, but it
may not be suitable in many cases. In particular, note that we effectively
assumed that Rosengarten was using its fixed assets at 100 percent of capacity
because any increase in sales led to an increase in fixed assets. For most
businesses, there would be some slack or excess capacity, and production
could be increased by perhaps running an extra shift.
If we assume that Rosengarten is operating at only 70 percent of capacity, then
the need for external funds will be quite different. When we say “70 percent of
capacity,” we mean that the current sales level is 70 percent of the fullcapacity sales level:
Current sales = $1,000 = .70 × Full-capacity sales
Full-capacity sales = $1,000/.70 = $1,429
This tells us that sales could increase by almost 43 percent—from $1,000 to
$1,429—before any new fixed assets would be needed, whereas the projected
sales increase is only 25%.
As a result, our original estimate of $565 in external funds needed is too high.
We estimated that $450 in new net fixed assets would be needed. Instead, no
spending on new net fixed assets is necessary. Thus, if we are currently
operating at 70 percent capacity, we need only $565 − 450 = $115 in external
4-20
funds.
EXAMPLE: OPERATING AT LESS
THAN FULL CAPACITY
Suppose that Rosengarten is currently operating at 90% capacity. What
would sales be at full capacity? What is the capital intensity ratio at full
capacity? What is EFN in this case?
Full-capacity sales would be $1,000/.90 = $1,111.
From Table 4.3, we know that fixed assets are $1,800. At full
capacity, the ratio of fixed assets to sales is this:
Fixed assets/Full-capacity sales = $1,800/$1,111 = 1.62
So, Rosengarten needs $1.62 in fixed assets for every $1 in sales
once it reaches full capacity. At the projected sales level of $1,250,
then, it needs $1,250 × 1.62 = $2,025 in fixed assets. Compared to
the $2,250 we originally projected, this is $225 less, so EFN is $565 −
225 = $340.
Current assets would still be $1,500, so total assets would be $1,500
+ 2,025 = $3,525. The capital intensity ratio would thus be
$3,525/$1,250 = 2.82
4-21
CHAPTER OUTLINE
1. What Is Financial Planning?
2. Financial Planning Models: A First Look
3. The Percentage of Sales Approach
4. External Financing and Growth
5. Some Caveats Regarding Financial
Planning Models
4-22
THE INTERNAL GROWTH RATE
There is a direct link between growth and external
financing. Two growth rates are particularly useful in longrange planning:
• The internal growth rate is the maximum growth rate a
firm can achieve without any external financing,
therefore EFN is zero (the required increase in assets is
exactly equal to the addition to retained earnings).
• The internal growth rate assumes that the dividend payout
ratio is constant.
𝑹𝑶𝑨 𝒙 𝒃
𝑰𝒏𝒕𝒆𝒓𝒏𝒂𝒍 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆 =
𝟏 − 𝑹𝑶𝑨 𝒙 𝒃
b = retention ratio (plowback) = 1 - dividend payout ratio
4-23
THE INTERNAL GROWTH RATE
For the Hoffman Company, net income was $66 and total assets
were $500. ROA is thus $66/$500 = .132, or 13.2%. Of the $66 net
income, $44 was retained, so the plowback ratio, b, is $44/$66 =
2/3. With these numbers, we can calculate the internal growth
rate:
𝑰𝒏𝒕𝒆𝒓𝒏𝒂𝒍 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆 =
𝑹𝑶𝑨 𝒙 𝒃
𝟏 − 𝑹𝑶𝑨 𝒙 𝒃
=0.132 × (2/3) / 1−0.132 × (2/3) = .0964, or 9.64%
Thus, the Hoffman Company can expand at a maximum rate of
9.64 percent per year without external financing.
4-24
THE SUSTAINABLE GROWTH RATE
The sustainable growth rate is the maximum growth
rate a firm can achieve without external equity
financing while maintaining a constant debt-equity
ratio.
• Assumptions:
• The sustainable growth rate also assumes that the dividend payout
ratio is constant.
• No new external equity is issued, but debt increases with growth.
𝑺𝒖𝒔𝒕𝒂𝒊𝒏𝒂𝒃𝒍𝒆 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆 =
𝑹𝑶𝑬 𝒙 𝒃
𝟏 − 𝑹𝑶𝑬 𝒙 𝒃
b = retention ratio (plowback) = 1 - dividend payout ratio
4-25
THE INTERNAL GROWTH RATE
For the Hoffman Company, net income was $66 and total equity
was $250; ROE is thus $66/$250 = .264, or 26.4%. The plowback
ratio, b, is still 2/3, so we can calculate the sustainable growth
rate as follows:
Sustainable 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆 =
𝑹𝑶𝑬 𝒙 𝒃
𝟏−𝑹𝑶𝑬 𝒙 𝒃
=0.264 × (2/3) / 1−0.264 × (2/3) = .2135, or 21.35%
Thus, the Hoffman Company can expand at a maximum rate of
21.35 percent per year without external equity financing and
maintaining its debt/equity ratio.
4-26
SUSTAINABLE GROWTH EXAMPLE
Suppose Hoffman grows at exactly the sustainable growth rate of 21.35 percent.
What will the pro forma statements look like?
At a 21.35 percent growth rate, sales will rise from $500 to $606.7. The pro forma
income statement will look like this:
HOFFMAN COMPANY
Pro Forma Income Statement
Sales (projected)
$606.7
Costs (83.3% of sales)
505.4
Taxable income
$101.3
Taxes (21%)
21.3
Net income
$80.0
Dividends
$26.7
Addition to retained earnings
53.4
Balance Sheet
Liabilities and Owners’ Equity
Assets
$
$
Current assets
$242.7
Total debt
$250.0
Net fixed assets
364.0
Owners’ equity
303.4
Total assets
$606.7
Total liabilities and owners’
equity
$553.4
External financing needed
$ 53.4
As illustrated, EFN is $53.4. If Hoffman borrows this amount, then total debt will rise to $303.4,
and the debt-equity ratio will be exactly 1.0, since equity has also increased by 53.4 –4-27
addition to retained earnings
THE DUPONT IDENTITY RECAP
The Du Pont Identity – popular expression breaking ROE into three
parts: operating efficiency, asset use efficiency, and financial
leverage:
 ROE = Net Income / Total Equity
• Multiply by 1 (TA/TA) and then rearrange:
 ROE = (Net Income / Total Equity)x(TA / TA)
 ROE = (Net Income / TA)x(TA / Total Equity)
 ROE =
 ROE =
ROA
ROA
x Equity Multiplier
x (1 + Debt-Equity ratio)
• Multiply by 1 (Sales/Sales) again, and then rearrange:
 ROE = (Net Income / TA)x(TA / Total Equity)x(Sales / Sales)
 ROE = (Net Income / Sales) x (Sales / TA) x (TA / TE)
 ROE =
ROA
x Equity Multiplier
 ROE = Profit Margin x Total Asset Turnover x Equity Multiplier 3-28
4-28
THE DUPONT IDENTITY RECAP
• ROE = PM * TAT * EM
 Profit margin is a measure of the firm’s operating efficiency
– how well does it control costs?
 Total Asset Turnover is a measure of the firm’s asset use
efficiency – how well does it manage its assets?
 Equity Multiplier is a measure of the firm’s financial
leverage
4-29
3-29
THE DUPONT IDENTITY RECAP
• Three ROE formulas giving the same answer:
1. ROE = NI / TE
2. ROE = ROA * Equity Multiplier
• ROE = ROA * TA/TE = ROA * (1 + TD/TE)
3. ROE = PM * TAT * EM
• ROE = NI/Sales * Sales/TA * TA/TE
• Two ROA formulas giving the same answer:
1. ROA = NI / TA
2. ROA = PM * TAT
• ROA = NI/Sales * Sales/TA
4-30
3-30
COMPUTING LONG-TERM
SOLVENCY RATIOS RECAP
Also called Financial Leverage Ratios or just Leverage
Ratios; Long-term ability to meet financial obligations
• Total Debt Ratio = TD / TA = (TA – TE) / TA =
(CL+LTD) / TA
(3,588 – 2,591) / 3,588 = 0.28 times (uses 28% debt, or
has $0.28 debt for every $1 in assets) i.e. $0.72 equity
for every $0.28 in debt  1 – TD/TA = TE/TA
Industry average: 22%
• Debt/Equity = TD / TE
997 / 2,591 = 0.39 times (debt represents 39% of Equity)
The D/E ratio indicates how much debt a company
is using to finance its assets relative to the value of
4-31
3-31
shareholders’ equity.
COMPUTING LONG-TERM
SOLVENCY RATIOS RECAP
• Equity Multiplier = TA / TE = (TE + TD) / TE = 1 + TD/TE
3,588/2,591 = 1.39; 1 + 0.39 = 1.39
Measures the level of debt financing in a business. The
higher the equity multiplier, the higher the level of
financial leverage (use of debt)
A high equity multiplier indicates the company has
been using more debt than equity to finance its asset
purchases.
The thing to notice here is that given any one of these
three ratios, you can immediately calculate the other
two; so, they all say exactly the same thing.
4-32
DETERMINANTS OF GROWTH
• Profit margin – operating efficiency
• Increase in PM  increase in sustainable growth
• Total asset turnover – asset use efficiency
• Increase in TAT  increase in sustainable growth
• Financial policy – choice of optimal debt ratio
• Increase in D/E ratio  increase in sustainable growth
• Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
• Increase in Retention Ratio  increase in sustainable growth
If a firm does not wish to sell new equity and its profit margin, dividend
policy, financial policy, and total asset turnover are all fixed, then there is
only one possible growth rate.
If sales are to grow at a rate higher than the sustainable growth rate, the firm
must increase profit margins, increase total asset turnover, increase financial
4-33
leverage, increase earnings retention, or sell new shares.
PROFIT MARGINS AND SUSTAINABLE
GROWTH
The Sandar Co. has a debt-equity ratio of .5, a profit margin of 3
percent, a dividend payout ratio of 40 percent, and a capital
intensity ratio of 1. What is its sustainable growth rate? If Sandar
desired a 10 percent sustainable growth rate and planned to
achieve this goal by improving profit margins, what would you
think?
ROE = PM x TAT x (1+D/E) = .03 × 1 × 1.5 = .045, or 4.5%. The
retention ratio is 1 − .40 = .60. Sustainable growth is thus
.045(.60)/[1 − .045(.60)] = .0277, or 2.77%.
For the company to achieve a 10 percent growth rate, the profit
margin will have to rise. To see this, assume that sustainable
growth is equal to 10 percent and then solve for profit margin,
PM:
.10 = PM(1.5)(.6)/[1 − PM(1.5)(.6)] Sustainable 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆 = 𝑹𝑶𝑬 𝒙 𝒃
𝟏−𝑹𝑶𝑬 𝒙 𝒃
PM = .1/.99 = .101, or 10.1%
For the plan to succeed, the necessary increase in profit margin is substantial, 4-34
from 3 percent to about 10 percent. This may not be feasible.
CHAPTER OUTLINE
1. What Is Financial Planning?
2. Financial Planning Models: A First Look
3. The Percentage of Sales Approach
4. External Financing and Growth
5. Some Caveats Regarding Financial
Planning Models
4-35
IMPORTANT QUESTIONS
• It is important to remember that we are
working with accounting numbers; therefore,
we must ask ourselves some important
questions as we go through the planning
process:
 How does our plan affect the timing and risk of our
cash flows?
 Does the plan point out inconsistencies in our
goals?
 If we follow this plan, will we maximize owners’
wealth?
4-36
QUICK QUIZ
• What is the purpose of long-range planning?
• What are the major decision areas involved in
developing a plan?
• What is the percentage of sales approach?
• How do you adjust the model when operating at
less than full capacity?
• What is the internal growth rate?
• What is the sustainable growth rate?
• What are the major determinants of growth?
4-37
END OF CHAPTER
CHAPTER 4
4-38